Is Crony Capitalism Wrong?

n November 29, 2011, Bloomberg Magazine’sRichard Teitelbaum published an article revealing a secret meeting on July 21, 2008, with then Secretary of the Treasury and former Goldman Sachs CEO Hank Paulson and around a dozen hedge-fund managers and Wall Street executives.

Five of the hedge fund managers were former Goldman Sachs employees. The meeting was held at the offices of the founder of hedge fund Eton Park Capital Management, Eric Mindich, a former 15-year employee of Goldman Sachs who rose to be the senior strategy officer of Goldman’s Executive Office. He is also current Chair of the Asset Managers’ Committee of the President’s Working Group on Capital Markets.

Then Secretary Paulson asked the hedge fund managers what the market might think if he placed mortgage giants Fannie Mae and Freddie Mac into conservatorship, a move that would have wiped out value for the shareholders and possibly wiped out value for subordinated debt holders.

According to the article, one hedge fund manager had a short position in these stocks when he walked into the meeting. He was shocked that Secretary Paulson blabbed specifics, and the hedge fund managers therefore believed the Treasury Department would implement the plan. Seven weeks later, it did.

The hedge fund manager called his lawyer at a break in the meeting, and his lawyer told him Paulson had divulged non-public material information. His lawyer advised him to stop trading in the shares of these companies immediately. Ironically, that meant the hedge fund manager could not cover his short positions, so he profited by riding the value of the shares all the way down to the bottom. If he hadn’t been at the meeting, and if he had any doubts, he might have covered his short position earlier and made less money. One will never know, because Secretary Paulson tied the hedge fund manager’s hands.

But the more interesting implication is for the other managers in attendance. If they didn’t already have a short position in Fannie Mae and Freddie Mac, they now had non-public material information that would allow them to almost certainly profit mightily by initiating such a trade. They could even be more confident in shorting other financial institutions that would likely take a shellacking.

Richard Teitelbaum quoted me: “What is this but crony capitalism? Most people have had their fill of it.”

Meanwhile, then Secretary Paulson told the public a different story than he told the meeting attendees. According to Bloomberg’s research, earlier that day, Paulson told the New York Times that the Federal Reserve and the Office of the Comptroller of the Currency were inspecting Fannie and Freddie’s books and he expected the result of this would inspire confidence. The Times’s article appeared the following day. Any investor in the shares of Fannie and Freddie would be less likely to sell their shares in the face of this reassuring message.

There is no way of knowing whether the hedge fund managers initiated new trades as a result of this meeting, but the key issue is that then Secretary of the Treasury Paulson communicated non-public material information that could financially benefit the recipients at the public’s expense.

Apparent Damage Control: That’s How They Roll

On Wednesday, November 30, 2011, I got a call from a staffer for Congressman Michael Quigley (D., IL.). Congressman Quigley represents Illinois’s 5th district. He replaced Rahm Emanuel, the current Mayor of Chicago, in a special election after Rahm resigned to become White House Chief of Staff. Rod Blagojevich preceded Rahm Emanuel. Blagojevich was elected Governor in 2002 and was subsequently impeached for corruption and misconduct and convicted of one count of lying to the FBI. He awaits sentencing.

Congressman Quigley’s staffer called because he saw my quote in the Bloomberg article. He claimed he was looking for clarification of my position, and I stated the article accurately reflected my viewpoint. But the staffer seemed to me to defend the meeting.

The staffer said this kind of meeting “happens all the time.” I retorted: “Really? What’s the excuse?”

He then claimed he was just trying to play “devil’s advocate.” But don’t we have a surplus of those?

The staffer claimed that people want to discuss regulations with people who might be affected. I responded that this excuse is ludicrous. Then Secretary of the Treasury Paulson discussed material non-public information about the restructuring of Fannie Mae and Freddie Mac with people who were in a position to profit at the expense of the public. I cut the phone call short at that point.

I would like to give my local politician the benefit of the doubt that a staffer wasn’t acting as an errand boy trying to send a message, but that phone call didn’t give me much to work with. It seems that whether it’s Henry Paulson working for a Republican administration or a Democratic errand boy doing apparent damage control, it looks as if we’re steeped in bi-partisan sleaze. If the staffer was merely playing the fool, then U.S. citizens needn’t suffer them gladly.

Janet Tavakoli is the president of Tavakoli Structured Finance, a Chicago-based firm that provides consulting to financial institutions and institutional investors. Ms. Tavakoli has more than 20 years of experience in senior investment banking positions, trading, structuring and marketing structured financial products. She is a former adjunct associate professor of derivatives at the University of Chicago's Graduate School of Business. Author of: Credit Derivatives & Synthetic Structures (1998, 2001), Collateralized Debt Obligations & Structured Finance (2003), Structured Finance & Collateralized Debt Obligations (John Wiley & Sons, September 2008). Tavakoli’s book on the causes of the global financial meltdown and how to fix it is: Dear Mr. Buffett: What an Investor Learns 1,269 Miles from Wall Street (Wiley, 2009).

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